Banking/financial crises

2. Banking/financial crises • Long history: 1819, 1838, 1857, 1893, 1907 • Bank runs • fractional reserve • Suspension of payments • No federal level deposit insurance

4. A new Central Bank • We had • First bank of the United States, 1791-1811 • Second bank of the US, 1816-1836 • Charter renewal vetoed by President Jackson in 1832 • New one: the Federal Reserve • Permanent charter • 12 districts • Board of Governors

6. What does the central bank do? • Modern days • Lender of last resort • Monetary policy • Regulation of banks

7. Money stock/interest rate • How does the central bank control money supply? • Open market operation • Buy/sell bonds • Demand/supply of bonds • That changes interest rate • Other factors: • How much currency do people hold?

8. Money creation • Money is not just cash in your pocket (currency) • Includes demand deposits, traveler’s checks • Saving deposits, small time deposits, money market mutual funds, etc • Currency to deposit: creates extra money in the banking system • Through money multiplier

9. Gold standard • 1900, Gold Standard Act • Globally, it means a fixed exchange rate • Everything is tied to gold • Benefits? • Costs? • Inflexibility in money supply • Fluctuations outside of economic force

10. Transmission mechanism • US productivity increase • Same amount of money, more goods • Prices fall • US goods cheaper • Britain buys more US goods • Gold inflow for US, outflow for Britain

11. Trade imbalances • US running a trade surplus, Britain deficit • Gold inflow for US, outflow for Britain • US price level goes up, Britain down • US goods more expensive, Britain goods cheaper • US buys more British goods • Built-in mechanism to balance trade

12. Gold Standard: Summary • Money supply tied to gold • In general, expect deflation • Built-in mechanism to balance trade • Relies on inflation when gold flows in • A country has no control over price level fluctuations • International forces will create business cycles • On top of domestic factors

13. Interest rate • With free flow of capital, money goes where the return is high • If interest rate is high, capital flows in • If interest rate is low, capital flows out

14. Stock Market Crash of 1929 • Similar to South Sea Bubble • 10/24/1929, 10/29/1929, black Thu/Tue • But has some “fundamentals” • Stock price and fundamental factors? • Fundamentals? Profitability, dividend • How are they related? • Future profitability • Booming economies of 1920’s

17. Was there “bubble”? • No • Booming economy • New Federal Reserve System, confidence • Yes • Economic boom might have initiated the bubble but not sustainable • Dividend growth not as high • Speculation

18. What caused the crash? • Increased supply of new stocks? • Smoot-Hawley tariff? • Should’ve hurt export industries • Small proportion • International stock markets? • Recessions? • Industrial production went down

19. NY Fed responded • To avoid the overall financial crisis • NY Fed open up discount window • Outside creditors demanded payment • Could cause widespread bankruptcy • Which in turn hurts the banking system

20. Repercussions • The Stock market crash does not equal to the Great Depression • Less than 5% held stock • Continued to trade after the crash • Large volumes through 1933 • Historical evidence: stock market crash did not always lead to recession

22. Economic Indicators: 1929-1940

23. Features of the Great Depression • Monetary contraction • Deflation • Caused by • Distrust of banking system • Contraction in monetary money stock • Expectation • Breakdown of banking system • Bank runs/failures • Channels to create money disrupted

24. High unemployment • 25% at one point • Definition varies after new deal • International aspect • Smoot Hawley Tariff • Other countries followed • Gold Standard fell apart • Commitment to GS became burdensome

25. Monetary Contraction • Because the contraction of money supply • At first, bursting the bubble • Tighten credit to curb speculation • Mechanism? • Did not increase money supply when they should • Inexperience? • Forming expectations of deflation

26. Deflation • But the Fed did not extend more credit • That means deflation persisted • Price 24% lower between 1929 and 1933 • consequences: debt deflation • Failed businesses, bankruptcy • Real interest rate= nominal interest rate-inflation • Deflation= negative inflation

27. Economic Indicators

28. Banking crises • Confidence in banking • Withdrawal of deposits • Higher reserve ratio • Reinforces the decrease in money supply • More credit to save the banks? • Solvent banks faced crises too • Not about insolvency, more about confidence • Lender of last resort!

29. Summary: Monetary Contraction • At first, expectation • Federal Reserve inaction • Reinforced by lack of confidence in banking system • Household behavior– hoarding cash • Bank’s response– raise reserve ratio

30. So far… • The stock market crash was only the beginning • Recessions and the Fed’s missteps • Expectation of falling price level • High real interest rate– investment falling • Deflation– low consumption • Collapse of financial system • But there was no “macroeconomics” yet

31. International Aspects • The Great Depression was a world wide phenomena • (hindsight) the earlier a country left GS, the sooner the recovery

32. Remember • The circular adjustment • Trade surplus • Money supply increase (gold flow in) • Price increase • Export decrease • Or trade deficit, gold outflow, price decrease, export decrease

33. France and Britain • This mechanism broke down • French gold inflow, Britain outflow • But French did not inflate • Thus more gold outflow for Britain, then finally go off gold standard

34. Why? • Commitment to GS requires • Tight control of monetary policy • Remember lower interest rate=expansionary monetary policy • If US lowers interest rates • Expand money supply • Price level rise • US $ worth less

35. (cont’d) • US $ worth less • Under GS • Say, US $ converts to 0.1 ounce of gold • But it’s only worth 0.05 ounce in the open market • What would you do? • “Speculative attacks” • The Fed could maintain GS so long as it meets the demand of speculators • But if it runs out of gold…

36. That means, US will have to keep the money supply low (interest rate high) • Economy suffers • Key: it was the commitment of GS that really fettered the monetary policy of the Fed

37. Recovery • 1933 FDR inaugurated • Hoover • “enlightened” conservative • Small government, high wages, etc • FDR • … the only thing we have to fear is fear itself • Debt financed new deal • Influenced by Keynes • Reshaped the role of government

39. Two new deals • First new deal • Banking (FDIC), securities market (SEC), Abandon GS, centralized power for Fed, NIRA, price support • Second new deal • Some of the first new deal acts ruled unconstitutional • Social security, unemployment insurance, Wagner act, work relief program

40. First New Deal 1933-35 • Banking reform • Glass-Steagall act • Firewall • FDIC • SEC (security exchange commission) • Information disclosure • AAA (Agriculture Adjustment Adm.) • Price support (floor) • reduction in output

41. First New Deal (cont’d) • National Industrial Recovery Act (NIRA) • Industry codes of “good behavior” • Industries set standards and enforced by gov’t • Price cooperation • Price floor, abstain from price cutting • High wages • Shorten the work week • Sanctioned trade union • PWA Public Works Adm • What was the diagnosis? • Effectiveness?

42. Second New Deal • NIRA and AAA ruled unconstitutional • NIRA too much power in the executive branch • AAA regulated agricultural production at the Federal level • Social Security • At first an insurance • Then Pay-as-you-go • Unemployment insurance

43. Wagner Act • Labor union encouragement • Work relief program • WPA Works Progress Adm. • Hire, educate workers • Public projects • Limit 30 hrs/week

44. Soil conservation and domestic allotment act (continuation of AAA) • Lower quantity to control price • Fair labor standards act • Minimum wage

45. Effectiveness? • Has to evaluate each individual policies • Examples: • Public Works: stimulated local economy • AAA & soil conservation: not as effective

46. Issues with the New Deal • Effectiveness? Economic sense? • Heavy handed regulation? • Role of the government in economic life • High wage rate: ideology • Distributive effects • Interest groups– northern businesses • Work relief programs • Political side • “swing states”? • Gaining political support

48. House Election Results 1932 1930 1934 1936

49. Dust Bowl • Dust bowl of 1930’s through 40’s • Drought • Sterile the arable land • Carried ton of fertile soil away • Loss in productivity (crop) $400 million annually • Destruction and Damaging crop, livestock, building, human health